The Bank of England is making a fundamental misjudgment about the British economy

Governor of the Bank of England Mark Carney hosts a quarterly Inflation Report press conference at the Bank of England in central London, Britain August 4, 2016. Reuters/Pool

The Bank of England is being too pessimistic about the UK's growth potential in the coming years, according to Pantheon Macroeconomics.

Mark Carney and his staff are underestimating the UK's rate of trend growth.

They believe it to be around 1.5%, while Samuel Tombs and his Pantheon team see growth at closer to 2%.

LONDON — The Bank of England is underestimating the growth potential of the British economy going forward, and in doing so could end up misjudging its policy path in 2018, according to research from Pantheon Macroeconomics.

Writing to clients on Monday, Pantheon's chief UK economist, Samuel Tombs argues that the bank's assertion that UK trend growth is around 1.5% — which estimates the long term average productive potential of the economy — is overly negative, and that the trend could actually be closer to 2%.

"Policymakers have continued to emphasise that the economy's speed limit is 1.5% and that spare capacity is modest, at just 0.25% of GDP," Tombs writes.

"As a result, the 1.8% increases in GDP that the MPC expects in each of the next three years will lead quickly to excess demand. Monetary policy works with a lag, so interest rates need to rise again soon, on this logic. Recent data, however, challenge the MPC's pessimism."

Pantheon argues that excessive slack — more workers than jobs — in the UK's labour market has not been absorbed.

"The economy has begun this year with slightly more slack than the MPC expected," Tombs writes.

"And there's every reason to think that this remaining slack won't be absorbed this year. Labour input can rise further without dragging down unemployment, given the clear scope for average hours to revive and the workforce to expand further."

Here's the key chart from Pantheon:

Pantheon Macroeconomics

A further issue that suggests overt pessimism on the Bank of England's part, Pantheon argue, is the structure of demographics in the UK's labour market. While it is true that the UK has an aging population, that aging is not going to rear its head as a problem for several more years.

Here's Tombs one last time (emphasis ours):

"The working-age population should continue to be boosted by high net migration. It fell immediately after the referendum, but since has stabilised at around 250K a year. Net inflows have risen from non-EU countries, offsetting some of the decline from EU countries. Admittedly, EU migrants are more likely to come to the U.K. to work than those from elsewhere. Even so, 248K people arriving in the year to September cited work reasons, slightly above the 232K average of the last decade.

"Brexit brings downside risks, but in order to secure a transition deal, Britain must accept the EU's free movement rules. The ageing of the population will become a major issue in the 2020s, when retiree numbers will surge, but the participation rate should edge up over the next two years."